Financial Instruments
Chapter 2
Major Types of Securities
debt
money market instruments
bonds
common stock
preferred stock
derivative securities
Markets and Instruments
Money Market
debt instruments
derivatives
Capital Market
bonds
equity
derivatives
Money Market
a subsector of fixed-income market
very short-term, marketable, liquid, low-risk debt securities (cash equivalents)
usually large denominations, so out of reach for individual investors
money market mutual funds make them
accessible to individuals by pooling resources from many investors
yields vary according to riskiness of securities (risk premium)
Money Market Instruments
Treasury Bills
discount bonds
maturities of 28, 91 or 182 days
minimum denominations of $10,000
income is exempt from all state and local taxes
highly liquid
Certificates of Deposit
time deposits with a bank
treated as deposits by FDIC (partially insured)
negotiable if denomination > $100,000 highly marketable if maturity < 3 months
Money Market Instruments (cont.)
Commercial Paper
unsecured debt by large, well-known
companies (usually backed by a line of credit)
maturities ≤ 270 days, usually 1-2 months
denomination is usually multiple of $100,000
Bankers Acceptances
like post-dated checks, selling at discount
foreign trade (unknown creditworthiness)
Eurodollars
USD-denominated deposits overseas
Money Market Instruments (cont.)
Repurchase Agreements (repos, RPs) and Reverse RPs
used by dealers in government securities
dealer sells government securities, usually overnight, and agrees to buy them back at a slightly higher price (1-day loan with collateral)
term repos – repurchase after ≥30 days
reverse repo – exactly the opposite of a repo
safe, since backed by government securities
Money Market Instruments (cont.)
Federal Funds
federal funds = reserves at the Fed
some banks have shortage of funds (required reserves > fed funds) overnight loans
interest rate = federal funds rate
Brokers’ Calls
brokers borrow from banks (on call) to fulfill orders on margin
LIBOR Market
LIBOR = London Interbank Offer Rate
Bond Markets
longer-term debt instruments
usually called the fixed-income capital market
instruments:
US Treasury Bonds and Notes
Agency Issues (Fed Gov)
International Bonds
Municipal Bonds
Corporate Bonds
Mortgage-Backed Securities
Bond Market Instruments
US Treasury Bonds and Notes
T-notes: maturity ≤ 10 years
T-bonds: maturity between 10 and 30 years, may be callable (usually during last 5 years)
since 2001, no maturity > 10 years
denominations ≥ $1,000
prices are quoted as percentage of par value
semi-annual interest payments – coupon payments
Bond Market Instruments (cont.)
Agency Issues (Federal Government)
usually to channel credit to particular sector of the economy that might not get enough credit through normal private sources
usually mortgage-related agencies (FHLB, FNMA, GNMA, FHLMC) – lend the money to S&Ls that can further lend it as mortgages
low risk (government owned or federally sponsored)
International Bonds (London)
Eurobond = not issued in domestic currency
Bond Market Instruments (cont.)
Municipal Bonds
issued by state and local governments
interest income is not subject to tax
2 types: general obligation and revenue bonds
to compare the yields on munis (rm) to other bonds use equivalent taxable yield:
or solve for the tax rate that equates the two yields:
t r rm
= − 1
t = 1 − rm
Bond Market Instruments (cont.)
Corporate Bonds
similar to Treasury issues, but with default risk
risk classification: secured, unsecured
(debentures), and subordinated debentures
feature classification: callable, convertible
current yield = annual coupon / price
Mortgage-Backed Securities
from securitization of mortgage loans
currently, bigger market than corporate bonds
guarantee interest and principal payments, but
Capital Market - Equity
Common Stock (Equity Securities, Equity)
gives owner (1) one vote at corporation’s annual meeting (also proxy) and (2) a share in financial benefits
residual claim = shareholders have a claim to what is left of a firm’s income or assets when liquidated, after other claimants have been paid
limited liability = the most shareholders can lose in case of failure is their initial investment
price/earnings ratio = price/earnings per share
Capital Market – Equity (cont.)
Preferred Stock
similar to bonds:
fixed dividends (like a perpetual bond)
paid before common stocks
no voting rights
can be redeemable (like callable bonds)
similar to stocks:
payment of dividends to the discretion of the firm (usually cumulative)
dividends are not tax exempt for the firm
Stock Market Indexes
Uses
track average returns
compare performance of managers
base of derivatives
Factors in constructing or using an Index
is it representative?
how broad should it be?
how is it constructed?
Price-Weighted Indexes
where pi is the price of security i and d is initially equal to the number of securities in the index
stock splits (n-for-1, stock j) change the divisor:
like a portfolio with one share of each stock
examples: Dow Jones Industrial Average
cautions: low number of stocks (frequent changes d
I =
∑
pi0
0 0
1
) / (
I
p n
d = p
j+ ∑
iValue-Weighted Indexes
where pi is the price of stock i, Ni is the
number of shares of stock i on the market, and I0 is the initial level of the index
like a portfolio with stock held in proportion with their market value
examples: Standard & Poor’s Composite 500, NASDAQ Composite, NYSE Composite
0 0 0
1 1
N I p
N I p
i i
i
i ×
=
∑
∑
Other Indexes
Equally-Weighted Indexes
equal dollar investments in each stock
would need readjustments every period
Foreign Indexes
Nikkei, FTSE (or Footsie), DAX, TSX etc.
International Indexes
MSCI computes indexes for over 50 countries and regions
Bond Market Indexes
Merrill Lynch, Lehman Brothers, Salomon Smith Barney
Derivative markets – Call Options
contracts that give the buyer the right to choose whether or not to buy a certain asset, on or
before a certain date (expiration date), at a predetermined price (exercise or strike price)
exercised when asset price rises
seller of option contract charges a premium, which is the per-share price of the contract
each contract is for 100 shares
call option prices increase with maturity and decrease with the strike price
Derivative markets – Put Options
contracts that give the buyer the right to choose whether or not to sell a certain asset, on or
before a certain date (expiration date), at a predetermined price (exercise or strike price)
exercised when asset price falls
seller of option contract charges a premium, which is the per-share price of the contract
each contract is for 100 shares
put options prices increase with maturity and with the strike price
Derivative markets – Futures
contracts for the delivery of a certain asset (or its cash value) on a certain date (delivery date), at a predetermined price (futures price)
trader who commits to purchasing the asset
takes the long position and profits when price
trader who commits to selling the asset takes the short position and profits when price
both parties are obliged to close their positions
one party’s loss is the other party’s profit
futures contracts are free
